Tax managed funds offer a solution to a problem that has in recent years diminished the appeal of mutual funds; that problem being the inability to minimize the tax impact for its investors. In general, mutual funds are a problem when it comes to tax time because when they make a substantial profit an investor is faced with paying capital gains tax. In fact, even when the fund may have had an overall loss, if stocks the fund has invested in are sold at a profit the tax laws still dictate that the income from that sale are distributed accordingly to the mutual fund holders and they are subject, again, to that capital gains tax. This is why the tax managed fund has become popular with many mutual fund investors.
Tax managed funds are operated in such a way as to manage the tax impact of the investor. One method that is employed is to reduce portfolio turnover, which means controlling the amount of buying and selling done over a certain time frame. Another method is to ensure that when some stocks have gained an offsetting sell of losing stocks is made thus keeping the tax liability in check. While the tax managed fund may control capital gains tax in this manner, funds that are producing a profit and performing well will eventually use up losses and still have gains which eventually create a tax liability for its shareholders.
Tax managed funds also manage capital gains by making purchases of portfolio holdings in multiple lots. This gives the manager of the fund an option of selecting shares with the least tax impact associated with them to pass along to the shareholders. Additionally, some tax managed funds charge fees to shareholders who sell their shares.
Taxes potentially have a big impact on overall returns with high portfolio turnover generating greater tax liability. However, the manager of a tax managed fund can lessen the impact of taxes in a variety of ways. But potential tax liability shouldn‘t be the main reason you choose a mutual fund, whether it is tax managed fund or not. After all, a good manager will make wise decisions regarding when to buy and sell stocks, anticipating the fluctuations in a stock’s value. Knowing when to buy or sell those stocks even if it does result in a tax liability. Because ultimately an investor wants to have a profit to pay taxes on. The choice of a tax managed fund can provide the best case scenario for both profit and tax liability.